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The aim of this article is to evaluate Tesco PLC (NYSE: OTCPK:TSCDY) according to their new strategy. Although investing at the current stock price level does not promise oversized returns, the company's real estate provides significant downside protection.

Tesco is one of the largest retailers in the world, focused mostly on food. For the last decade, the company has steadily expanded in Central Europe and Asia; the international sales now constitute about one third of revenue. The remaining two thirds come from the UK where the company has about 30% share of the grocery market. (The company is headquartered in the UK and uses GBP as the reporting currency, thus I will use British pounds and pence throughout this article.)

Although Tesco has increased dividends each year for 27 years until 2012, this streak has ended now and the dividend stayed flat this year. This should not come as a big surprise: the market share in the UK has been declining for a few years together with customer satisfaction, the trading profit in Central Europe has fallen by 38%, China is in a slowdown and the ventures in Japan and the USA turned out to be unprofitable beyond remedy. This year, the company has written off 800M of UK property, registered 500M of goodwill impairment mainly in Poland and Turkey and decided to exit USA, booking an additional 1.2B loss. However, not all is bleak and the future looks promising.

The new CEO appointed in 2011 is very candid in acknowledging problems and the management is working hard to get back on track. Apparently, the rapid growth of about 11-14% p. a. during the last years of the previous CEO's tenure has led to some misallocation of capital and the cost cutting had eroded UK customers' satisfaction and loyalty. The new management is addressing both of these problems in their new strategy (see the presentation or the 2013 annual report). I will summarize the new business plan and then calculate the value of the company and the expected rate of return on an investment. The calculations are based mostly on the guidance given by the management because the historical numbers do not fit with the new strategy.

Why do I think one can trust the management estimates? First, the management seems to be open and honest when discussing problems the company currently has; they seem to be far from accounting gimmicks or other ways of covering up (for instance, they openly admit the pension fund deficit increase). Their guidance also gives a large amount of detail, which is open to investor scrutiny over time. They have laid out the UK turnaround strategy more than a year ago; it seems to be working (though not spectacularly due to tough overall economic conditions) and they stick to it. The management also has the courage to act and close unprofitable divisions as they demonstrated with the Japan and US operations. Moreover, both the old and new management appear shareholder friendly.

Second, the company as such has a proven track record; in words of Warren Buffett, it is no broken-down nag: from 2005 to 2012, revenues and dividends have increased about twofold and earnings have increased even through the 2008/9 recession. (However, the current 38% decline in Central European trading profit shows that the company is not totally recession proof.) The return on capital employed (ROCE) is very consistent in the range of 12% to 15%; this demonstrates that the company can invest retained earnings in a favourable way and grow without fancy acquisitions.

(click to enlarge)

Table 1: Historical data (in billions of pounds except for ratios).

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Table 2: Per-share data (pence).

The tables indicates that the last decade can be characterized by aggressive growth; almost no FCF was generated and most of the profits were channeled into new investment. Both borrowing and a sale and leaseback programme of significant scale in the UK provided new capital to be deployed into international growth. This period has now definitely ended.

Business plans

Multichannel retailing

Tesco is trying to find a good plan to use its well-located stores: about 500M is being invested into technology to blend online retail with existing stores. The online grocery business has grown by 12.8% in the last year and is now established in every country where Tesco operates. The advantage of the online business (currently 3B in sales) is that much lower capex is needed to expand it, and this fits very well into the new strategy (see the section on capital allocation).

UK business

The investment of 1B in UK to create a more pleasant shopping trip for customers decreased the UK profit margin to 5.2% and the company does not expect any margin increase in the future. The results are encouraging, both customer satisfaction and supplier view have improved. Although total UK sales improved by 1% in 1Q2013, like-for-like sales have decreased by 1%, mainly dragged down by non-food merchandise and the horsemeat scandal.

Tesco clearly states that food is their priority and they are cutting down selling space devoted to less profitable non-food wares, often decreasing the total store area and renting the available space to other retailers.

There is no doubt that dunnhumby, the data analytics subsidiary of Tesco, gives a lot of insight into customer behavior, which will help the management to successfully address all the issues here, so I expect further moderate improvement. However, if the overall situation in Europe deteriorates, there might occur a slight loss of market share to Asda (subsidiary of WMT), which also has a capable management and is targeting less wealthy and economically pressured customers.

International growth

The advantage of Tesco is that it operates in a few rather diverse countries and can choose where to invest. Currently, the management plans to invest mostly in Thailand, Malaysia and Korea where they see good near-term growth prospects.

The long-term outlook for their business in Europe is fine, but it is not the time to devote much new capital. The food retail market in Central Europe enjoyed many new store openings in recent years and is saturated for now. Apart from starting the online food offering in Bratislava, the strategy in Slovakia has been to open smaller stores (Tesco Express) closer to customers; however, many regions of Slovakia enjoy high unemployment and new stores in those regions simply do not make sense until overall economic conditions improve. I live in Slovakia and fully agree with the chosen strategy.

China, Turkey and India promise exciting long-term opportunities, but management decided to slow down growth and take a steady and careful approach instead. A few not enough profitable stores in China have been closed and focus is given to only three provinces; capital will be employed only if very satisfactory rate of return is achieved.

Tesco Bank

Tesco Bank is focused on simple products (e.g. savings deposits) and currently has started to offer mortgages. Excluding some accounting adjustments, the bank profits have grown 13% to 158M and account for about 5% of total profits. In other words, Tesco bank is becoming a significant part of the business. But not only it generates profits of its own, but it also plays an important role in increasing customer loyalty: bank customers are 50% more likely to use another Tesco channel or service than Clubcard customers, and an average customer increases his spending by about 12% when migrated from Clubcard to Tesco Bank Clubcard. I believe that this gives Tesco a competitive advantage against other retailers.

The F&F brand

Tesco is developing the F&F clothing brand as an important part of their strategy. Sales of F&F-branded merchandise exceeded 1B in the UK alone and are growing by 9% a year. Fifty new franchise stores are planned to be opened in the Middle East and other Asian countries over the next 5 years in cooperation with established franchise operators Al Hokair and Al Futtaim.

From my own experience, the F&F brand offers many attractively priced goods of good quality. For instance, my pair of sandals cost just 6 euros, and although it withstood quite a lot of rough usage during hiking over the last three years, it is still in a rather good condition.

Capital allocation changes

According to the 2013 annual report, the CEO is firmly determined on tightening the capital discipline. Capital expenditures are planned to gradually decrease to 4% and then 3.5% of sales. The priority is to generate significant free cash flow; this is an important change of the strategy: the business has generated positive FCF only sporadically in the previous years. The company aims at a higher ROCE in the range of 12 to 15 percent.

The transition to positive FCF generation must be gradual. In the last decade, profits realized on the sale and leaseback programme funded a significant portion of capex, but Tesco plans to curtail this program. Profits on property-related items decreased from 400M to 370M from 2012 to 2013. Currently, capex is broadly equivalent to the cash available from operations; but after the UK refresh plans are carried out, it will decrease further, so there will be no need to rely on property profits. (More on this plan can be found on pages 22-23 of the AR.)

If we assume that the UK profit margin stays at 5.2% as planned (and the net profit margin in Asia and Europe will not be much smaller), it would mean about 1B of FCF which would approximately cover the current 1.2B of dividends distributed to shareholders. The management expects that the planned capex would allow yearly earnings increase in the mid-single digit range, and unless profit margins are substantially reduced, this should cover dividend increases in the same range. The payout ratio currently stays at about 40% of adjusted earnings, well in line with the plan of dividends not exceeding 50% of earnings. This estimate leaves about nothing for share buybacks, so I do not expect any meaningful repurchases.

Balance sheet

Tesco owns plenty of real estate in the form of their own stores and adjacent shopping malls. The market value of all the properties is about 38B, of that 20B in the UK. Since the properties are carried at cost of 25B in books, the company owns much more tangible assets than judged from the balance sheet. Of course, the value of the properties is enhanced by the footfall resulting from the existing Tesco stores, thus the liquidation value would be smaller.

During the last year, the assets have been reassessed in the light of the new strategy, and this led to property impairments of about 800M in the UK and a goodwill impairment of 500M in other European countries. Moreover, the US venture Fresh & Easy has been closed, resulting in a loss of about 1.2B. Consequently, the accounting profit for 2013 was almost nil and the equity has decreased by about 1.2B. I believe that such huge write-downs will not repeat in the coming years.

The company consistently operates with negative working capital because it sells goods sooner than it pays its suppliers. Since I am valuing the company as a going concern, I will assume that this current assets shortfall of 5.9B remains about the same in the future. If we remove goodwill from the balance sheet and replace the book value of the properties by their market value, we arrive at non-current assets of 45B versus non-current liabilities of 14B. This gives about 31B of net income-producing assets, which sell at only 27.5B of market cap. In my opinion, this provides quite a lot of downside protection and possibly even a small margin of safety. (The share price declined from 477 to about 300 during the 2008 turmoil; however, Tesco traded with a much larger P/B multiple before the crisis.)

Cash flow from operations covers fixed charges (rent and interest expense) almost four times. Net debt calculated by the company stands at 6.6B (less than 40% of equity), a decrease of 0.2B during the last year. I believe this debt level is not dangerous and could be further reduced if desired; the focus on FCF -- and operating results showing it -- assure me that the company can pay its bills on time.

Risks

The retail market is extremely competitive both in the UK and in most other countries where Tesco operates. Some of the competitors also offer groceries online (Asda, Sainsbury's). History offers mountains of tales of mismanaged retailers (see Carrefour or J. C. Penney as recent examples), and even those not-so-badly managed often failed to deliver expected profits. And although the company does not depend on a particular CEO, it probably cannot be run by a ham sandwich either.

There is a real risk of the UK margin narrowing further. A 1% decline in net profit margin would mean about 15% decline in earnings. Even a larger decline is possible: food retailers in Germany operate with margins thinner than 2%, thus the UK's 5% looks quite rich.

The risk of losing reputation materialized in the horsemeat scandal: equine DNA was discovered in a few products claimed to be bovine, some of them being sold by Tesco. This resulted in a decline of sales of frozen and chilled products.

There is some political and regulatory risk, probably not significant, but still very real: forced changes in opening hours in Korea led to a loss of sales and a special Hungarian crisis tax cut down net profit. Working capital had to be increased in some countries because of regulatory changes reducing creditor days.

The balance sheet is rather strong. A rise in interest rates will not be fatal for the company because only about 25% of the debt is in floating rate form (this debt is mostly indexed to retail prices). However, profits may suffer if rates rise rapidly.

Tesco bank is managed so that its net interest income is not sensitive to interest rate changes. However, banks have risks of their own. Luckily, this one is not large yet and thus even if it went bankrupt it will not bring down the whole company. I have to admit that I do not understand banks well enough to give any credible opinion on risks associated with the Tesco bank, but to me as a customer the bank is appealing: unlike most other banks, it has a less risky profitable business backing it, and thus I perceive the credit risk to be smaller with this bank than other small banks.

Tesco has established itself in various foreign countries and has developed some strategies for penetrating new markets. However, this was not enough to avoid unsuccessful ventures into the US and Japan, and such unpleasant development might occur again in the future.

Moat

The advantage of food retailers is that their business is rather recession resistant. However, although everyone has to buy groceries, economic pressures can change customer habits. Here Tesco is not in a very strong position because there are high-end retailers like Waitrose competing for wealthier customers and bargain retailers offering lowest possible prices without much regard for the quality of the shopping trip. Tesco might get squeezed in the middle.

Another advantage of an established retailer is the control of good locations. It simply does not pay off to go too far to get those few daily-needed items. However, in larger cities there are usually many competing supermarkets in the vicinity.

I like the idea of online grocery; it really saves time to shop online instead of visiting a hypermarket. It is not possible to have a successful online grocery business without a sophisticated distribution network and good relationships with suppliers, thus the number of competitors for general online food retail will always be limited. However, Asda alone might prove to be enough. (To mitigate such risk one can buy WMT too.)

Tesco decided to cut margins to offer better customer experience and higher quality foods. At the same time, it aspires to be the UK low-cost retailer with their Price Promise. Interestingly, Asda is offering even a 10 percent discount to Tesco prices, and other competitors also have their own offers of this kind (see a comparison of price offers). Tesco automatically gives vouchers for the price difference both in-store and online. This gives a strong incentive for existing customers not to leave, but might not be enough to attract new ones. Nevertheless, I think that the decision to sacrifice current profit margins to protect long-term market share is a step in a good direction.

One of the signs of a great business is that it can raise prices without losing customers. This is definitely not the case of food retailers. There are no strong brands associated with Tesco; the F&F-branded items offer good value, but they are attractive mostly because they are cheap. Warren Buffett owns about 5% of Tesco, so he sees some moat here, but I do not think that the competitive advantages of Tesco are particularly strong.

Valuation

Because 2012/13 earnings are almost zeroed by the non-recurring write-downs listed above, I will use underlying diluted earnings per share instead of ordinary EPS. This measure has tightly reflected EPS over the last decade. Moreover, the 2013 underlying EPS number of 35.97p is about equal to the 3- or 5-year average of this measure. The dividend was 14.76p for 2012/13 and the current stock price is 344p (and thus Tesco trades at P/E ratio less than 10).

My first valuation approach is to use the Dividend Discount Model. The following table shows the expected rate of return depending on the future growth of earnings (and dividends).

(click to enlarge)Expected rates of return.

The second approach uses Buffett's idea of owner earnings to determine the intrinsic value. According to the presentation of preliminary 2012/13 results, maintenance and refreshing capex stands at about 1.6B, in line with depreciation and amortization. The most troublesome part is what one should take as reported earnings to get a meaningful estimate.

First, we do not want to go too many years back because Tesco has been rapidly increasing the number of stores, so data from 5 years ago do not really reflect the current situation. Moreover, the UK margin has permanently shrunk, so I will not use any profit numbers from before 2012. Second, there is a significant decline in operating profit in 2013 because of one-time restructuring costs and various write-downs. I have decided to take the last year's after-tax profits from continuing operations (1.386B) as a proxy for future earnings. This number includes about 800M of UK restructuring-related costs and 495M of goodwill impairment (see Note 2 in AR), so I adjust it accordingly to remove the effect of these one-time charges. The resulting earnings estimate is 2.7B. We can arrive at approximately the same number by taking underlying operating profit before tax (3.549B) and applying the effective tax rate, which varied from 20 to 30 percent in recent years.

The owner's earnings are thus 2.7B plus 1.6B of depreciation minus about 1.6B of maintenance capex, which amounts to 2.7B. The following table shows the present intrinsic value depending on the discount rate used. It was calculated with 8.04B of diluted shares outstanding.

Owner

Maybe a comment on the choice of the discount rate is warranted. One can easily invest in an index fund with historical returns of about 10% p. a., thus to buy an individual stock instead, a fairly strong conviction of either higher expected returns or lower risk is needed. I think that Tesco is a bit less risky than an average business, and the income stream obtained by owning Tesco is much more stable than that obtained from an index ETF. Therefore, I am willing to accept 10 or even 9 percent return here; moreover, I feel much more comfortable holding Tesco shares than government bonds now.

Conclusion

Why invest in Tesco?

  • capable shareholder-friendly management, transparent communication
  • clear vision and viable strategy
  • downside protection thanks to the real estate
  • almost zero risk of a one-time event crippling the company (one has to always think of this when buying oil producers or nuclear utilities)
  • nice dividend yield of 4.3% with very reasonable payout ratio (about 40%); zero withholding tax for US investors

Why not to invest:

  • narrow margin of safety, if any
  • you see better opportunities
  • possible return of only 8-9% would make you unhappy
  • currency risk -- earnings come in mostly in British pounds

I am not particularly concerned about Europe's slowdown; the sky will clear in a few years and business will thrive again. Of course, I hope for a nice dip in the share price to get even higher returns.

Source: Tesco: Fair Returns With Limited Downside

Additional disclosure: I have a significant long position and had to fight confirmation and other biases quite a lot during my analysis. I am no expert on retail or management, just a common-sense amateur investor, so take this with a grain of salt.